Memorandum by the Department for Transport,
Local Government and the Regions (NAT 2)

BACKGROUND

1. On 27 March 2001 the Government announced
that the Airline Group (AG), a consortium of seven airlines, had
been chosen as the Government's strategic partner in the public-private
partnership (PPP) which it proposed to establish for National
Air Traffic Services (NATS). The transaction was completed on
26 July 2001. AG acquired 46 per cent of the shares in NATS. The
Government retained 49 per cent of the shares, and 5 per cent
were put into an employee share trust. The PPP arrangements arising
from AG's proposal contained a borrowing facility made available
to NATS by four banks.

2. The attack on the World Trade Centre
on 11 September 2001 led to a downturn in air traffic, particularly
on transatlantic routes. This had a serious impact on NATS' revenues,
which are directly dependent on traffic volumes. They are also
dependent on distance flown in NATS-managed airspace, which includes
the whole of the UK plus the north-east North Atlantic. Prior
to 11 September transatlantic flights, which typically travel
the length of the UK as well as flying through our oceanic airspace,
had accounted for 44 per cent of NATS' revenues.

3. The extent of the revenue problem depends
on assumptions about the rate of recovery in air traffic. NATS
has developed revised demand forecasts and agreed them with its
shareholders and lenders. Based on these revised forecasts, NATS
calculated that it would need to increase prices over the period
to 2005, as well as taking action to cut costs, in order to make
good the forecast revenue shortfall. The significance of 2005
is that it marks the end of the first five-year period of charge
control for NATS, during which NATS' maximum charges have already
been set.

ACTIONTO
RESTORE NATS' POSITION

4. NATS' management, the Government and
AG as shareholders, the Civil Aviation Authority (CAA) as economic
regulator and the four lending banks all recognise the need to
restore NATS' financial position in the light of the loss of revenue.
All parties have acknowledged the need to work together and contribute
to a long-term solution.

5. Two key actions have been taken by NATS
to address the situation:

 The company has revised its business
plan to reflect the impact of 11 September. In particular, it
has taken measures to reduce its costs which, broadly, will save
£200 million in the first charging period.

 The company has also addressed the
question of its prices. NATS is not at liberty simply to increase
its charges to offset lost revenues, as its counterparts throughout
Europe have done. The latter have increased prices by an average
of 12 per cent for 2002, whereas NATS, operating within its price
cap, has marginally reduced its prices in cash terms to meet the
requirement for a year on year change 3 per cent below inflation.
NATS has now applied to the CAA for a review of the charge cap
which has been set for the years 2003 to 2005, to take account
of the exceptional circumstances created by the attacks on 11
September. The CAA, in accordance with the role established for
it under the Transport Act 2000, will act as an independent regulator
in carrying out the review.

6. The cost cutting measures have already
been implemented. But the CAA can only announce the conclusions
of its review of the price cap after due consideration and consultation.
NATS and its shareholders are also considering other means of
strengthening the balance sheet. Even under the reduced budget,
taking account of the cost cutting measures, which has been approved
by the shareholders, NATS would be unable to sustain its operations
until the completion of those processes without adequate borrowing
facilities being available.

7. The Government and the banks have therefore
agreed to make available to NATS a short-term working capital
facility. The facility is for a maximum of £60 million,
to be provided equally by the banks and the Government, repayable
not later than 30 September 2002. Each party will lend on the
same, fully commercial terms. It should be noted that without
the PPP in place, the Government would have borne the full cost
of the loan facility, rather than sharing it equally with the
private sector.

IMPLICATIONSFOR
AIR TRAFFIC
CONTROL

8. The UK Government has an international
obligation under the Chicago Convention to ensure the provision
of air traffic control services in the airspace for which it has
responsibility. There are compelling economic reasons why the
continuation of adequate services is a high priority. And, as
a paramount requirement, in exercising his functions under the
Transport Act 2000 the Secretary of State must ensure that a high
standard of safety is maintained in the provision of those services.
The actions taken and envisaged in relation to NATS' financial
situation are intended to ensure that those obligations can all
be met.

9. The Government will take no actions which
it believes might compromise safety. The Transport Act provides
for the maintenance of safe services in the event of financial
failure by a company providing services under the Act. If necessary
the Government would activate those provisions. It does not, however,
wish to do so; neither does it expect to need to do so.

10. The Government notes that, despite the
difficulties which followed 11 September, NATS' New En Route Control
Centre at Swanwick opened on 27 January 2002, in accordance with
the timetable set some 18 months earlier.

IMPLICATIONSFORTHE TWO-CENTRE
STRATEGY

11. The two-centre strategy requires NATS
to develop the proposed New Scottish Centre at Prestwick in addition
to the Swanwick centre.

12. As part of its response to the events
of 11 September, NATS re-assessed the capital investment programme
put foward by AG in its bid. The Company was in any case contractually
obliged to re-visit the programme in the course of preparing a
business plan after the completion of the PPP. In the circumstances,
it had to take account both of its own changed financial prospects
and of changes in demand for its services.

13. NATS concluded that it would be prudent
to defer the New Scottish Centre, probably by 18 months to two
years. The precise length of the deferral would depend on trends
in traffic volumes as they emerged, but broadly the new centre
would come into operation by 2009 instead of 2007 as required
by the terms of the PPP. AG sought a corresponding amendment to
those terms and the Government agreed.

14. The delay is temporary, and work has
not ceased. Site preparations and piling work have already been
carried out. NATS is engaged with suppliers in evaluating systems,
and expects to commence the competitive selection process during
2002.

15. The capacity of the present Scottish
and Oceanic Area Control Centre at Prestwick will be sufficient
to meet forecast traffic demand in the meantime. The technology
is in place to introduce new control sectors if necessary and
existing equipment is being upgraded, with the installation of
a new radar processing system. Safety will not be affected. The
Government would not have agreed to the proposed delay had there
been any prospect of safety being jeopardised.